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Chapter 04 - The Income Statement and Statement of Cash Flows

Chapter 4
Flows

The Income Statement and Statement of Cash

QUESTIONS FOR REVIEW OF KEYQuestion 4-1 TOPICS


The income statement is a change statement that reports transactions revenues, expenses, gains and losses that cause owners equity to change during a specified reporting period.

Question 4-2
Income from continuing operations includes the revenue, expense, gain, and loss transactions that will probably continue in future periods. It is important to segregate the income effects of these items because they are the most important transactions in terms of predicting future cash flows.

Question 4-3
Operating income includes revenues and expenses and gains and losses that are directly related to the principal revenue generating activities of the company. Nonoperating income includes items that are not directly related to these activities.

Question 4-4
The single-step format first lists all revenues and gains included in income from continuing operations to arrive at total revenues and gains. All expenses and losses are then grouped and subtotaled, subtracted from revenues and gains to arrive at income from continuing operations. The multiple-step format reports a series (multiple) of intermediate totals such as gross profit, operating income, and income before taxes. Very often income statements adopt variations of these formats, falling somewhere in between the two extremes.

Question 4-5
The term earnings quality refers to the ability of reported earnings (income) to predict a companys future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value.

Question 4-6
Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations. They are reported as an operating expense in the income statement.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Question 4-7
The process of intraperiod tax allocation matches tax expense or tax benefit with each major component of income, specifically continuing operations and any item reported below continuing operations. The process is necessary to achieve the desired result of separating the total income effects of continuing operations from the two separately reported items - discontinued operations and extraordinary items, and also to show the after-tax effect of each of those two components.

Answers to Questions (continued) Question 4-8


The net-of-tax income effects of a discontinued operation must be disclosed separately in the income statement, below income from continuing operations. The income effects include income (loss) from operations and gain (loss) on disposal. The gain or loss on disposal must be disclosed either on the face of the statement or in a disclosure note. If the component is held for sale but not sold by the end of the reporting period, the income effects will include income (loss) from operations and an impairment loss if the fair value less costs to sell is less than the book value of the components assets. The income (loss) from operations of the component is reported separately in discontinued operations on prior income statements presented for comparative purposes.

Question 4-9
Extraordinary items are material gains and losses that are both unusual in nature and infrequent in occurrence, taking into account the environment in which the entity operates.

Question 4-10
Extraordinary gains and losses are presented, net of tax, in the income statement below discontinued operations, if any.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Answers to Questions (continued) Question 4-11


GAAP permit alternative treatments for similar transactions. Common examples are the choice among FIFO, LIFO, and average cost for the measurement of inventory and the choice among alternative revenue recognition methods. A change in accounting principle occurs when a company changes from one generally accepted treatment to another. In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous periods financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. Specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders equity (or statements of retained earnings if theyre presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. In the first set of financial statements after the change, a disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the retained earnings balance was revised in the statement of shareholders equity along with the cumulative effect of the change in retained earnings. An exception is a change in depreciation, amortization, or depletion method. These changes are accounted for as a change in estimate, rather than as a change in accounting principle. Changes in estimates are accounted for prospectively. The remaining book value is depreciated, amortized, or depleted, using the new method, over the remaining useful life.

Question 4-12
A change in accounting estimate is accounted for in the year of the change and in subsequent periods; prior years financial statements are not restated. A disclosure note should justify that the change is preferable and should describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.

Question 4-13
Prior period adjustments are accounted for by restating prior years financial statements when those statements are presented again for comparison purposes. The beginning of period retained earnings is increased or decreased on the statement of shareholders equity (or the statement of retained earnings) as of the beginning of the earliest period presented.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Answers to Questions (concluded) Question 4-14


Earnings per share (EPS) is the amount of income achieved during a period for each share of common stock outstanding. If there are different components of income reported below continuing operations, their effects on earnings per share must be disclosed. If a period contains discontinued operations and extraordinary items, EPS data must be reported separately for income from continuing operations and net income. Per share amounts for discontinued operations and extraordinary items would be disclosed on the face of the income statement.

Question 4-15
Comprehensive income is the total change in equity for a reporting period other than from transactions with owners. Reporting comprehensive income can be accomplished with a separate statement or by including the information in either the income statement or the statement of changes in shareholders equity.

Question 4-16
The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise during a period. Similar to the income statement, it is a change statement, summarizing the transactions that caused cash to change during a particular period of time.

Question 4-17
The three categories of cash flows reported on the statement of cash flows are: 1. Operating activities Inflows and outflows of cash related to the transactions entering into the determination of net income from operations. 2. Investing activities Involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets. 3. Financing activities Involve cash inflows and outflows from transactions with creditors and owners.

Question 4-18
Noncash investing and financing activities are transactions that do not increase or decrease cash but are important investing and financing activities. An example would be the acquisition of property, plant and equipment (an investing activity) by issuing either long-term debt or equity securities (a financing activity). These activities are reported either on the face of the statement of cash flows or in a disclosure note.

Question 4-19
The direct method of reporting cash flows from operating activities presents the cash effect of each operating activity directly on the statement of cash flows. The indirect method of reporting cash flows from operating activities is derived indirectly, by starting with reported net income and adding and subtracting items to convert that amount to a cash basis.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Question 4-20
There are two possible separately reported items that could appear in income statements, discontinued operations and extraordinary items. International Financial Reporting Standards (IFRS) prohibit reporting extraordinary items.

Question 4-21
IFRS provides the option of presenting components of other comprehensive income either in (a) a single statement of comprehensive income or (b) in a separate income statement followed by a statement of comprehensive income. U.S. GAAP also allows the reporting of other comprehensive income in the statement of shareholders equity

Question 4-22
U.S. GAAP designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. IFRS allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities

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Chapter 04 - The Income Statement and Statement of Cash Flows

BRIEF EXERCISES
Brief Exercise 4-1
PACIFIC SCIENTIFIC CORPORATION Income Statement For the Year Ended December 31, 2011 $2,106 45 2,151 $1,240 126 105 35 258 1,764 $ 387

($ in millions)

Revenues and gains: Sales .................................................................. Gain on sale of investments ............................... Total revenues and gains ............................... Expenses and losses: Cost of goods sold ............................................. Selling................................................................ General and administrative................................. Interest............................................................... Income tax expense* ......................................... Total expenses and losses .............................. Net income ........................................................... *$2,151 (1,240 + 126 + 105 + 35) = $645 x 40% = $258 Sales revenue Brief Exercise 4-2 Less: Cost of goods sold Gross profit Less: Selling expenses (126) General and administrative expenses (105) Operating income $ 635 (b) Gain on sale of investments Interest expense
Nonoperating income

(a)

$2,106 (1,240) 866

45 (35)
$10

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-3

PACIFIC SCIENTIFIC CORPORATION Income Statement For the Year Ended December 31, 2011
($ in millions)

Sales revenue ....................................................... Cost of goods sold ............................................... Gross profit .......................................................... Operating expenses: Selling................................................................ General and administrative................................. Total operating expenses ............................... Operating income ................................................. Other income (expense): Gain on sale of investments ............................... Interest expense ................................................. Total other income, net .................................. Income before income taxes ............................... Income tax expense* ............................................ Net income ........................................................... *$645 x 40% $126 105

$2,106 1,240 866

231 635 45 (35) 10 645 258 $ 387

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-4


(a)

Sales revenue Less: Cost of goods sold General and administrative expenses Restructuring costs Selling expenses Operating income Operating income Add: Interest revenue Deduct: Loss on sale of investments Income before income taxes and Extraordinary item Income tax expense (40%) Income before extraordinary item Income before extraordinary item Extraordinary item: Loss from flood damage, net of $20,000 tax benefit Net loss

$300,000 (160,000) (40,000) (50,000) (25,000) $ 25,000 $25,000 4,000 (22,000) 7,000 (2,800) $ 4,200 $ 4,200 (30,000) (25,800)

(b)

(c)

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-5


MEMORAX COMPANY Partial Income Statement For the Year Ended December 31, 2011 Income before income taxes and extraordinary item............ Income tax expense* ........................................................... Income before extraordinary item ....................................... Extraordinary item: Loss from earthquake, net of $208,000 tax benefit........... Net income ........................................................................... *$790,000 x 40% $ 790,000 316,000 474,000 (312,000) $ 162,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-6


WHITE AND SONS, INC. Partial Income Statement For the Year Ended December 31, 2011 Income before income taxes and extraordinary item............ Income tax expense* ........................................................... Income before extraordinary item ....................................... Extraordinary item: Loss from earthquake, net of $160,000 tax benefit........... Net income ........................................................................... Earnings per share: Income before extraordinary item........................................ Loss from earthquake .......................................................... Net income .......................................................................... *$850,000 x 40% Note: Restructuring costs, interest revenue, and loss on sale of investments are included in income before income taxes and extraordinary item. $ 850,000 340,000 510,000 (240,000) $ 270,000 $ 5.10 (2.40) $ 2.70

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-7


CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2011 Income from continuing operations before income taxes..... Income tax expense* ............................................................ Income from continuing operations ..................................... Discontinued operations: Loss from operations of discontinued component (including gain on disposal of $2,000,000)** ........................... Income tax benefit ............................................................ Loss on discontinued operations ....................................... Net income ........................................................................... * $5,800,000 x 30% ** Loss from operations of discontinued component: Gain on sale of assets Operating loss Total before-tax loss $ 2,000,000 ($10 million less $8 million) (3,600,000) $(1,600,000) $ 5,800,000 1,740,000 $ 4,060,000 (1,600,000) 480,000 (1,120,000) $ 2,940,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-8


CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2011 Income from continuing operations before income taxes..... Income tax expense* ............................................................ Income from continuing operations ..................................... Discontinued operations: Loss from operations of discontinued component** ......... Income tax benefit ............................................................ Loss on discontinued operations ....................................... Net income ........................................................................... * $5,800,000 x 30% ** Includes only the operating loss. There is no impairment loss. $ 5,800,000 1,740,000 $ 4,060,000 (3,600,000) 1,080,000 (2,520,000) $ 1,540,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-9


CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2011 Income from continuing operations before income taxes..... Income tax expense* ............................................................ Income from continuing operations ..................................... Discontinued operations: Loss from operations of discontinued component (including impairment loss of $1,000,000)** ............................ Income tax benefit ............................................................ Loss on discontinued operations ....................................... Net income ........................................................................... * $5,800,000 x 30% ** Loss from operations of discontinued component: Impairment loss ($8 million book value less $7 million net fair value) Operating loss Total before-tax loss $(1,000,000) (3,600,000) $(4,600,000) $ 5,800,000 1,740,000 $ 4,060,000 (4,600,000) 1,380,000 (3,220,000) $ 840,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-10


The change in inventory method is a change in accounting principle. The depreciation method change is considered to be a change in accounting estimate that is achieved by a change in accounting principle and is accounted for prospectively, exactly as we would account for any other change in estimate. The inventory method change, however, is accounted for by retrospectively recasting prior years financial statements presented with the current year for comparative purposes, applying the new inventory method (FIFO in this case) in those years. This is a change in accounting estimate.

Brief Exercise 4-11

When an estimate is revised as new information comes to light, accounting for the change in estimate is quite straightforward. We do not restate prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from there on. If the after-tax income effect of the change in estimate is material, the effect on net income and earnings per share must be disclosed in a note, along with the justification for the change. Depreciation for 2011 is $25,000: Cost $ 50,000 Previous annual depreciation ($300,000 6 years) x 2 years 100,000 Depreciation to date (2009-2010) 200,000 Book value __ 8 yrs. Estimated remaining life (10 years - 2 years) $ 25,000 New annual depreciation $300,000

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Brief Exercise 4-12

OREILLY BEVERAGE COMPANY Statement of Comprehensive Income For the Year Ended December 31, 2011 $650,000 $ 24,000 (36,000) (12,000) $638,000

Net income ........................................................... Other comprehensive income (loss): Unrealized gains on investment securities, net of tax ........................................................ Deferred loss on derivatives, net of tax ............ Total other comprehensive loss ........................... Comprehensive income ........................................

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-13


Cash Flows from Operating Activities: Collections from customers Interest on note receivable Interest on note payable Payment of operating expenses Net cash flows from operating activities $ 660,000 12,000 (18,000) (440,000) $214,000

Only these four cash flow transactions relate to operating activities. The others are investing and financing activities.

Brief Exercise 4-14Cash Flows from Investing Activities:

Proceeds from note receivable collection $100,000 Sale of land 40,000 Purchase of equipment (120,000) Net cash flows from investing activities $20,000 $200,000 (30,000) 170,000

Cash Flows from Financing Activities: Issuance of common stock Payment of dividends Net cash flows from financing activities

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Chapter 04 - The Income Statement and Statement of Cash Flows

Brief Exercise 4-15


Cash Flows from Operating Activities: Net income Adjustments for noncash effects: Depreciation expense Changes in operating assets and liabilities: Increase in prepaid rent Increase in salaries payable Increase in income taxes payable Net cash inflows from operating activities $45,000 80,000 (60,000) 15,000 12,000 $92,000

Under IFRS, interest received and interest paid usually classified as investing and financing cash flows, respectively, not operating cash flows as with U.S. GAAP. The revised cash flow categories usually would appear as follows:

Brief Exercise 4-16are

Cash Flows from Operating Activities: Collections from customers Payment of operating expenses Net cash flows from operating activities Cash Flows from Investing Activities: Proceeds from note receivable collection Sale of land Interest on note receivable Purchase of equipment Net cash flows from investing activities Cash Flows from Financing Activities: Issuance of common stock Payment of dividends Interest on note payable Net cash flows from financing activities

$ 660,000 (440,000) $220,000 $100,000 40,000 12,000 (120,000) $32,000 $200,000 (30,000) (18,000) 152,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

EXERCISES
Exercise 4-1
Requirement 1 GREEN STAR CORPORATION Income Statement For the Year Ended December 31, 2011 Revenues and gains: Sales .................................................................. Interest .............................................................. Gain on sale of investments ............................... Total revenues and gains ............................... Expenses and losses: Cost of goods sold ............................................. Salaries............................................................... Depreciation....................................................... Interest............................................................... Rent.................................................................... Income tax ......................................................... Total expenses and losses .............................. Net income ........................................................... Earnings per share ............................................... $720,000 160,000 50,000 40,000 25,000 130,000 1,125,000 $ 255,000 $2.55 $1,300,000 30,000 50,000 1,380,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-1 (concluded) Requirement 2 GREEN STAR CORPORATION Income Statement For the Year Ended December 31, 2011 Sales revenue ....................................................... Cost of goods sold ............................................... Gross profit .......................................................... Operating expenses: Salaries............................................................... Depreciation....................................................... Rent ................................................................... Total operating expenses ............................... Operating income ................................................. Other income (expense): Interest revenue ................................................. Gain on sale of investments ............................... Interest expense ................................................. Total other income, net .................................. Income before income taxes ............................... Income tax expense ............................................. Net income ........................................................... Earnings per share ............................................... $160,000 50,000 25,000 235,000 345,000 30,000 50,000 (40,000) 40,000 385,000 130,000 $ 255,000 $2.55 $1,300,000 720,000 580,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-2
Requirement 1 GENERAL LIGHTING CORPORATION Income Statement For the Year Ended December 31, 2011 Revenues and gains: Sales .................................................................. Rental revenue .................................................. Total revenues and gains ............................... Expenses and losses: Cost of goods sold ............................................. Salaries .............................................................. Depreciation....................................................... Interest............................................................... Rent ................................................................... Loss on sale of investments ............................... Loss from inventory write-down ....................... Income tax expense *......................................... Total expenses and losses .............................. Income before extraordinary item ........................ Extraordinary item: Loss from flood damage (net of $48,000 tax benefit) Net income ........................................................... Earnings per share: Income before extraordinary item ........................ Extraordinary loss ................................................ Net income ........................................................... * 40% x $467,200 $1,200,300 300,000 100,000 90,000 50,000 22,500 200,000 186,880 2,149,680 280,320 (72,000) $ 208,320 $ .93 (.24) $ .69 $2,350,000 80,000 2,430,000

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Exercise 4-2 (concluded) Requirement 2 GENERAL LIGHTING CORPORATION Income Statement For the Year Ended December 31, 2011 Sales revenue ....................................................... Cost of goods sold ............................................... Gross profit .......................................................... Operating expenses: Salaries .............................................................. Depreciation ...................................................... Rent ................................................................... Loss from inventory write-down ....................... Total operating expenses ............................... Operating income ................................................. Other income (expense): Rental revenue .................................................. Loss on sale of investments ............................... Interest expense ................................................. Total other income (expense), net ................. Income before taxes and extraordinary item ........ Income tax expense *............................................ Income before extraordinary item ........................ Extraordinary item: Loss from flood damage (net of $48,000 tax benefit) Net income ........................................................... Earnings per share: Income before extraordinary item ........................ Extraordinary loss ................................................ Net income ........................................................... * 40% x $467,200 $300,000 100,000 50,000 200,000 650,000 499,700 80,000 (22,500) (90,000) (32,500) 467,200 186,880 280,320 (72,000) $ 208,320 $ .93 (.24) $ .69 $2,350,000 1,200,300 1,149,700

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-3
LINDOR CORPORATION Statement of Income and Comprehensive Income For the Year Ended December 31, 2011 Sales revenue .................................................................... Cost of goods sold ............................................................ Gross profit ....................................................................... Operating expenses: Selling and administrative............................................... Operating income ............................................................. Other income (expense): Interest expense ................................................................ Income before income taxes and extraordinary item ........ Income tax expense *........................................................ Income before extraordinary item ..................................... Extraordinary item: Gain on litigation settlement (net of $120,000 tax expense) ................................................................... Net income Other comprehensive income: Unrealized holding gains on investment securities, net of tax .................................................................... Comprehensive income ..................................................... Earnings per share: Income before extraordinary item ..................................... Extraordinary gain ............................................................ Net income ....................................................................... * 30% x $440,000 $2,300,000 1,400,000 900,000 420,000 480,000 (40,000) 440,000 132,000 308,000 280,000 588,000 56,000 $644,000 $ 0.31 0.28 $ 0.59

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Exercise 4-4
AXEL CORPORATION Income Statement For the Year Ended December 31, 2011 Sales revenue .................................................................... Cost of goods sold ............................................................ Gross profit ....................................................................... Operating expenses: Selling ........................................................................... Administrative .............................................................. Restructuring costs ........................................................ Total operating expenses ............................................ Operating income ............................................................. Other income (expense): Interest and dividends .................................................... Interest expense ............................................................. Total other income, net ................................................. Income before income taxes and extraordinary item ....... Income tax expense* ........................................................ Income before extraordinary item ..................................... Extraordinary item: Gain on litigation settlement (net of $34,400 tax expense) ................................................................... Net income ....................................................................... Earnings per share: Income before extraordinary item ..................................... Extraordinary gain ............................................................ Net income ....................................................................... * 40% x $64,000 $67,000 87,000 55,000 209,000 58,000 32,000 (26,000) 6,000 64,000 25,600 38,400 51,600 $ 90,000 $ .38 .52 $0.90 $ 592,000 325,000 267,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-5
CHANCE COMPANY Partial Income Statement For the Year Ended December 31, 2011 Income from continuing operations ..................................... Discontinued operations: Loss from operations of discontinued component (including loss on disposal of $400,000)* ................................ Income tax benefit ............................................................ Loss on discontinued operations ....................................... Net income ........................................................................... Earnings per share: Income from continuing operations ..................................... Loss from discontinued operations ...................................... Net income .......................................................................... * Loss on discontinued operations: Loss on sale of assets Operating loss Total before-tax loss Less: Income tax benefit (40%) Net-of-tax loss $(400,000) (130,000) (530,000) 212,000 $(318,000) $ 350,000 (530,000) 212,000 (318,000) $ 32,000 $ 3.50 (3.18) $ .32

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-6
ESQUIRE COMIC BOOK COMPANY Partial Income Statement For the Year Ended December 31, 2011 Income from continuing operations * ................................... Discontinued operations: Income from operations of discontinued component (including loss on disposal of $350,000) .................................. Income tax expense ........................................................... Income on discontinued operations ................................... Net income............................................................................ $ 552,000

150,000 60,000 90,000 $642,000

* Income from continuing operations: Income before considering additional items Decrease in income due to restructuring costs Before-tax income from continuing operations Income tax expense (40%) Income from continuing operations $1,000,000 (80,000) 920,000 (368,000) $ 552,000

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Exercise 4-7
Requirement 1 KANDON ENTERPRISES, INC. Partial Income Statement For the Year Ended December 31, 2011 Income from continuing operations ..................................... Discontinued operations: Loss from operations of discontinued component (including impairment loss of $50,000) * ............................... Income tax benefit............................................................. Loss on discontinued operations ....................................... Net income .......................................................................... * Loss on discontinued operations: Operating loss Impairment loss ($250,000 - 200,000) Net before-tax loss Income tax benefit (40%) Net after-tax loss on discontinued operations Requirement 2 KANDON ENTERPRISES, INC. Partial Income Statement For the Year Ended December 31, 2011 Income from continuing operations ..................................... Discontinued operations: Loss from operations of discontinued component *.......... Income tax benefit ............................................................ Loss on discontinued operations ....................................... Net income .......................................................................... $ 400,000 (140,000) 56,000 (84,000) $ 316,000 $(140,000) (50,000) (190,000) 76,000 $(114,000) $ 400,000

(190,000) 76,000 (114,000) $ 286,000

*Includes only the operating loss during the year. There is no impairment loss.

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Exercise 4-8
Pretax income from continuing operations Income tax expense Income from continuing operations Less: Net income Loss from discontinued operations $14,000,000 (5,600,000) 8,400,000 7,200,000 $1,200,000

$1,200,000 60%* = $2,000,000 = before tax loss from discontinued operations. *1-tax rate of 40% = 60% Pretax income of division Add: Loss from discontinued operations Impairment loss Fair value of divisions assets Add: Impairment loss Book value of divisions assets $4,000,000 2,000,000 $6,000,000 $11,000,000 6,000,000 $17,000,000

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Exercise 4-9
Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the companys knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Canliss reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change would be depreciated using the straight-line method over the remaining useful life. A disclosure note should justify that the change is preferable and should describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Requirement 2 Assets cost Accumulated depreciation to date ($320,000 + 192,000) To be depreciated over remaining 3 years 2011 straight-line depreciation: $288,000 3 years = $96,000 Adjusting entry: Depreciation expense (calculated above)....................... Accumulated depreciation ........................................ 96,000 96,000

$800,000 (512,000) $288,000

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Exercise 4-10
Requirement 1 This is a change in accounting estimate. Requirement 2 When an estimate is revised as new information comes to light, accounting for the change in estimate is quite straightforward. We do not restate prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from there on. If the after-tax income effect of the change in estimate is material, the effect on net income and earnings per share must be disclosed in a note, along with the justification for the change. Requirement 3 $800,000 $160,000 x 2 years 320,000 480,000 __ 6 yrs. $ 80,000 Cost Previous annual depreciation ($800,000 5 years) Depreciation to date (2009-2010) Book value Estimated remaining life (8 years - 2 years) New annual depreciation

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Exercise 4-11
Requirement 1 This is a change in accounting estimate. Requirement 2 $2,400,000 $240,000 x 21/2 yrs. 600,000 1,800,000 __ 5 yrs. $ 360,000

Cost Previous annual amortization ($2,400,000 10 years) Amortization to date (2009-2011) Book value Estimated remaining life (given) New annual amortization

Exercise 4-12

Earnings per share: Income from continuing $5.00 (1.60) 2.20 $5.60

operations Loss from discontinued operations Extraordinary gain Net income

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Exercise 4-13
Requirement 1 THE MASSOUD CONSULTING GROUP Statement of Income and Comprehensive Income (in part) For the Year Ended December 31, 2011 Net income ........................................................... Other comprehensive income (loss): Foreign currency translation gain, net of tax ..... Unrealized losses on investment securities, net of tax ........................................................ Total other comprehensive income ...................... Comprehensive income ........................................ $1,354,000 $168,000 (56,000) 112,000 $1,466,000

Requirement 2

THE MASSOUD CONSULTING GROUP Statement of Comprehensive Income For the Year Ended December 31, 2011 Net income ........................................................... Other comprehensive income (loss): Foreign currency translation gain, net of tax ..... Unrealized losses on investment securities net of tax ........................................................ Total other comprehensive income ...................... Comprehensive income ........................................ $1,354,000 $168,000 (56,000) 112,000 $1,466,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Requirement 1 U.S. GAAP also permits the presentation comprehensive income items in the statement of shareholders equity.

Exercise 4-14

of

other

Requirement 2 IAS No. 1 also allows companies to report other comprehensive income items in either a combined statement of income and comprehensive income or in a separate statement of comprehensive income. Presentation in the statement of shareholders equity is not permitted.

Exercise 4-15cash.
salaries. 3. a_ 4. c_ 5. b_ 6. c_ 7. b_ 8. a_ 9. d_ 10. c_ 11. c_

1.___ b 2.___ a

Purchase of equipment for Payment of employee

Collection of cash from customers. Cash proceeds from a note payable. Purchase of common stock of another corporation for cash. Issuance of common stock for cash. Sale of machinery for cash. Payment of interest on note payable. Issuance of bonds payable in exchange for land and building. Payment of cash dividends to shareholders. Payment of principal on note payable.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-16

Bluebonnet Bakers Statement of Cash Flows For the Year Ended December 31, 2011

Cash flows from operating activities: Collections from customers $ 380,000 Interest on note receivable 6,000 Purchase of inventory (160,000) Interest on note payable (5,000) Payment of salaries (90,000) Net cash flows from operating activities Cash flows from investing activities: Collection of note receivable Sale of investments Purchase of equipment Net cash flows from investing activities Cash flows from financing activities: Proceeds from note payable Payment of note payable Payment of dividends Net cash flows from financing activities Net increase in cash Cash and cash equivalents, January 1 Cash and cash equivalents, December 31 50,000 30,000 (85,000)

$131,000

(5,000) 100,000 (25,000) (20,000) 55,000 181,000 17,000 $ 198,000

4-33

Chapter 04 - The Income Statement and Statement of Cash Flows

Cash collected for interest, considered an operating cash flow by U.S. GAAP, could be classified as either an operating cash flow or an investing cash flow according to International Accounting Standards. Cash paid for interest, considered an operating cash flow by U.S. GAAP, could be classified as either an operating cash flow or a financing cash flow according to International Accounting Standards. Cash paid for dividends, considered a financing cash flow by U.S. GAAP, could be classified as either an operating cash flow or a financing cash flow according to International Accounting Standards. Accordingly, the statement of cash flows prepared according to IFRS could be the same as under U.S. GAAP (E4-16) or could be presented as follows:

Exercise 4-17

Bluebonnet Bakers Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities: Collections from customers $ 380,000 Purchase of inventory (160,000) Payment of salaries (90,000) Payment of dividends (20,000) Net cash flows from operating activities Cash flows from investing activities: Collection of note receivable Interest on note receivable Sale of investments Purchase of equipment Net cash flows from investing activities Cash flows from financing activities: Proceeds from note payable Payment of note payable Interest on note payable Net cash flows from financing activities Net increase in cash Cash and cash equivalents, January 1 Cash and cash equivalents, December 31 50,000 6,000 30,000 (85,000) 1,000 100,000 (25,000) (5,000) 70,000 181,000 17,000 $ 198,000

$110,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-18

Cash flows from operating activities: Net income $17,300 Adjustments for noncash effects: Depreciation expense 7,800 Changes in operating assets and liabilities: Increase in accounts receivable (4,000) Decrease in inventory 5,500 Decrease in prepaid insurance 1,200 Decrease in salaries payable (2,700) Increase in interest payable 800 Net cash flows from operating activities $25,900 Requirement 1 Financing 1. $300,000 2. Investing Operating $(10,000) $ (5,000) (6,000) (70,000) 55,000
__________

Exercise 4-19
3. 4. 5. 6. 7. 8. 9.
__________

__________

$300,000

$(10,000)

$(26,000)

$264,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-19 (concluded) Requirement 2


Wainwright Corporation Statement of Cash Flows For the Month Ended March 31, 2011 Cash flows from operating activities: Collections from customers Payment of rent Payment of one-year insurance premium Payment to suppliers of merchandise for sale Net cash flows from operating activities Cash flows from investing activities: Purchase of equipment Net cash flows from investing activities Cash flows from financing activities: Issuance of common stock Net cash flows from financing activities Net increase in cash Cash and cash equivalents, March 1 Cash and cash equivalents, March 31 Noncash investing and financing activities: Acquired $40,000 of equipment by paying cash and issuing a note as follows: Cost of equipment $40,000 Cash paid 10,000 Note issued $30,000 $ 55,000 (5,000) (6,000) (70,000) $ (26,000) (10,000) (10,000) 300,000 300,000 264,000 40,000 $ 304,000

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-20

Cash flows from operating activities: Net income $624,000 Adjustments for noncash effects: Depreciation and amortization expense 87,000 Changes in operating assets and liabilities: Decrease in accounts receivable 22,000 Increase in inventories (9,200) Increase in prepaid expenses (8,500) Increase in salaries payable 10,000 Decrease in income taxes payable (14,000) Net cash flows from operating activities $711,300 Consistent with U.S. GAAP, international standards also Exercise 4-21require a statement of cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing. However, the U.S. standard designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. IAS No. 7, on the other hand, allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities. Accordingly, the statement of cash flows prepared according to IFRS mostly likely would be presented as follows (differences from U.S. GAAP in italics):
Bronco Metals Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities: Collections from customers Purchase of inventory Payment of operating expenses Net cash flows from operating activities Cash flows from investing activities: Interest on note receivable Dividends received from investments Collection of note receivable Purchase of equipment Net cash flows from investing activities Cash flows from financing activities:
4-37

$ 353,000 (186,000) (67,000) $100,000 4,000 2,400 100,000 (154,000) (47,600)

Chapter 04 - The Income Statement and Statement of Cash Flows

Payment of interest on note payable Proceeds from issuance of common stock Dividends paid Net cash flows from financing activities Net increase in cash Cash and cash equivalents, January 1 Cash and cash equivalents, December 31

(8,000) 200,000 (40,000) 152,000 204,400 28,600 $233,000

4-38

Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-22

Tiger Enterprises Statement of Cash Flows For the Year Ended December 31, 2011 ($ in thousands)

Cash flows from operating activities: Net income $ 900 Adjustments for noncash effects: Depreciation expense 240 Changes in operating assets and liabilities: Decrease in accounts receivable 80 Increase in inventory (40) Increase in prepaid insurance (30) Decrease in accounts payable (60) Decrease in administrative and other payables (100) Increase in income taxes payable 50 Net cash flows from operating activities $1,040 Cash flows from investing activities: Purchase of plant and equipment Cash flows from financing activities: Proceeds from issuance of common stock 100 Proceeds from note payable 200 Payment of dividends (1) (940) Net cash flows from financing activities(640) Net increase in cash Cash, January 1 Cash, December 31
Retained earnings, beginning $540 (1) + Net income 900 - Dividends x x = $940 Retained earnings, ending $500

(300)

100 200 $ 300

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-23

The T-account analysis of the transactions related to operating cash flows is shown below. To derive the cash flows, the beginning and ending balances in the related assets and liabilities are inserted, together with the revenue and expense amounts from the income statements. In each balance sheet account, the remaining (plug) figure is the other half of the cash increases or decreases.
Cash Flows (Operating) (a.) 7,080 (b.) 130 (c.) 3,460 (d.) 1,900 (e.) 550 Sales Revenue Accounts Receivable 1/1 830 (a.) 7,080 7,000 <-----------> 7,000 12/31 750 Insurance Expense 100 <-----------> 100

Prepaid Insurance 1/1 20 (b.) 130 12/31 50

Accounts Payable Inventory (c.) 3,460 1/1 360 1/1 600 3,400 <-----------> 3,400 12/31 300 12/31 640 Admin. & Other Payables (d.) 1,900 1/1 400 1,800 <-----------> 12/31 300 Income Taxes Payable (e.) 550 1/1 150 600 <-----------> 12/31 200

3,360 <----------->

Cost of Goods Sold 3,360

Admin. & Other Expense 1,800

Income Tax Expense 600

Based on the information in the T-accounts above, the operating activities section of the SCF for Tiger Enterprises would be as shown next.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-23 (concluded) Tiger Enterprises Statement of Cash Flows For the Year Ended December 31, 2011 ($ in thousands) Cash flows from operating activities: Collections from customers $ 7,080 Prepayment of insurance (130) Payment to inventory suppliers (3,460) Payment for administrative & other exp. (1,900) Payment of income taxes (550) Net cash flows from operating activities

$ 1,040

4-41

Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-24
Requirement 1 FASB ASC 260: Earnings per Share. Requirement 2 The specific citation that describes the additional information for earnings per share that must be included in the notes to the financial is FASB ASC 26010501: Earnings per ShareOverallDisclosure. Requirement 3

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Chapter 04 - The Income Statement and Statement of Cash Flows

For each period for which an income statement is presented, an entity discloses all of the following:

4-43

Chapter 04 - The Income Statement and Statement of Cash Flows

a. A reconciliation of the numerators and the denominators of the basic and diluted per-share computations for income from continuing operations. The reconciliation includes the individual income and share amount effects of all securities that affect earnings per share (EPS). Example 2 (see paragraph 260-10-55-51) illustrates that disclosure. (See paragraph 260-10-45-3.) An entity is encouraged to refer to pertinent information about securities included in the EPS computations that is provided elsewhere in the financial statements as prescribed by Subtopic 505-10. b. The effect that has been given to preferred dividends in arriving at income available to common stockholders in computing basic EPS. c. Securities (including those issuable pursuant to contingent stock agreements) that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because to do so would have been antidilutive for the period(s) presented. Full disclosure of the terms and conditions of these securities is required even if a security is not included in diluted EPS in the current period. For the latest period for which an income statement is presented, an entity must provide a description of any transaction that occurs after the end of the most recent period but before issuance of the financial statements that would have changed materially the number of common shares or potential common shares outstanding at the end of the period if the transaction had occurred before the end of the period. Examples of those transactions include the issuance or acquisition of common shares; the issuance of warrants, options, or convertible securities; the resolution of a contingency pursuant to a contingent stock agreement; and the conversion or exercise of potential common shares outstanding at the end of the period into common shares.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-25
The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is: 1. The criteria for determining if a gain or loss should be reported as an extraordinary item: FASB ASC 22520452: Income StatementExtraordinary and Unusual ItemsOther Presentation MattersCriteria for Presentation as Extraordinary. Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Thus, both of the following criteria shall be met to classify an event or transaction as an extraordinary item: a. Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. b. Infrequency of occurrence. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. 2. The calculation of the weighted average number of shares for basic earnings per share purposes: FASB ASC 26010552: Earnings per ShareOverallImplementation Guidance and IllustrationComputing a Weighted Average. The weighted-average number of shares is an arithmetical mean average of shares outstanding and assumed to be outstanding for EPS computations. The most precise average would be the sum of the shares determined on a daily basis divided by the number of days in the period. Less-precise averaging methods may be used, however, as long as they produce reasonable results. Methods that introduce artificial weighting, such as the Rule of 78 method, are not acceptable for computing a weighted-average number of shares for EPS computations.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-25 (concluded) 3. The alternative formats permissible for reporting comprehensive income: FASB ASC 22010458: Comprehensive IncomeOverallOther Presentation ItemsAlternative Formats for Reporting Comprehensive Income. An entity shall display comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements that constitute a full set of financial statements. This Subtopic does not require a specific format for that financial statement but requires that an entity display net income as a component of comprehensive income in that financial statement. Examples 1 through 2 (paragraphs 220-10-55-4 through 5527) provide illustrations of the components of other comprehensive income and total comprehensive income being reported below the total for net income in a statement that reports results of operations, in a separate statement of comprehensive income that begins with net income, and in a statement of changes in equity. 4. The classifications of cash flows required in the statement of cash flows: FASB ASC 23010451: Statement of Cash FlowsOverallOther Presentation MattersForm and Content. A statement of cash flows shall report the cash effects during a period of an entity's operations, its investing transactions, and its financing transactions.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Exercise 4-26
f g 1. Intraperiod tax allocation 2. Comprehensive income

List A

List B

a 3. Extraordinary items l 4. Operating income

k 5. A discontinued operation j 6. Earnings per share

d 7. Prior period adjustment e 8. Financing activities h 9. Operating activities (SCF) i 10. Investing activities c 11. Direct method b 12. Indirect method

a. Unusual, infrequent, and material gains and losses. b. Starts with net income and works backwards to convert to cash. c. Reports the cash effects of each operating activity directly on the statement. d. Correction of a material error of a prior period. e. Related to the external financing of the company. f. Associates tax with income statement item. g. Total nonowner change in equity. h. Related to the transactions entering into the determination of net income. i. Related to the acquisition and disposition of long-term assets. j. Required disclosure for publicly traded corporation. k. A component of an entity. l. Directly related to principal revenuegenerating activities.

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Chapter 04 - The Income Statement and Statement of Cash Flows

CPA / CMA REVIEW QUESTIONS


CPA Exam Questions
1. c. U.S. GAAP requires that discontinued operations be disclosed separately below income from continuing operations. 2. d. Other than sales, COGS, and administrative expenses, only the gain or loss from disposal of equipment is considered part of income from continuing operations. Income from continuing operations was ($5,000,000 - 3,000,000 1,000,000 + 200,000) = $1,200,000. 3. a. In a single-step income statement, revenues include sales as well as other revenues and gains. Sales revenue Interest revenue Gain on sale of equipment Total $187,000 10,200 4,700 $201,900

The discontinued operations and the extraordinary gain are reported below income from continuing operations. 4. a. The $400,000 impairment loss and the $1,000,000 loss from operations should be combined for a total loss of $1,400,000.
5.

d. The change in the estimate for warranty costs is based on new information obtained from experience and qualifies as a change in accounting estimate. A change in accounting estimate affects current and future periods and is not accounted for by restating prior periods. The accounting change is a part of continuing operations.

6. a. Dividends paid to shareholders is considered a financing cash flow, not an operating cash flow. 7. c. Issuing common stock for cash is considered a financing cash flow, not an investing cash flow.

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Chapter 04 - The Income Statement and Statement of Cash Flows

4-49

Chapter 04 - The Income Statement and Statement of Cash Flows

CMA Exam Questions


1. d. Discontinued operations and extraordinary gains and losses are shown

separately in the income statement, below income from continuing operations. The cumulative effect of most voluntary changes in accounting principle is accounted for by retrospectively revising prior years financial statements.
2. c. The operating section of a retailers income statement includes all revenues

and costs necessary for the operation of the retail establishment, e.g., sales, cost of goods sold, administrative expenses, and selling expenses. 3 a. Extraordinary items should be presented net of tax after income from operations.

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Chapter 04 - The Income Statement and Statement of Cash Flows

PROBLEMS
Problem 4-1
REED COMPANY Comparative Income Statements For the Years Ended December 31 2011 $4,000,000 2,570,000 1,430,000 750,000 340,000 50,000 35,000 1,175,000 255,000 150,000 (200,000) (50,000) 205,000 82,000 123,000
[6] [7]

Sales revenue .........................................................[1] Cost of goods sold ................................................[2] Gross profit ........................................................... Operating expenses: Administrative .....................................................[3] Selling .................................................................[4] Loss from fire damage ......................................... Loss from write-down of obsolete inventory ....... Total operating expenses ................................. Operating income .................................................. Other income (expense): Interest revenue .................................................... Interest expense ................................................... Total other expenses (net) ............................... Income from continuing operations before income taxes and extraordinary item................ Income tax expense ............................................... Income from continuing operations before extraordinary item.............................................. Discontinued operations: Income (loss) from operations of discontinued component (including loss on disposal of $50,000 in 2011) ................................................ Income tax benefit (expense)................................. Income (loss) on discontinued operations ..........[5] Income before extraordinary item ......................... Extraordinary item: Loss from earthquake (net of $40,000 tax benefit) . Net income ............................................................
Earnings per share: Income from continuing operations before extraordinary item..................................................... Discontinued operations ............................................. Extraordinary loss ...................................................... Net income ...................................................................

2010 $3,000,000 1,680,000 1,320,000 635,000 282,000 --917,000 403,000 140,000 (200,000) (60,000) 343,000 137,200 205,800

[8] [9]

(10,000) 4,000 (6,000) 117,000 $ (60,000) 57,000

110,000 (44,000) 66,000 271,800 -$ 271,800

.41 (.02) (.20) $ .19

.69 .22 -$ .91

4-51

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-1 (concluded) [1] $4,400,000 - 400,000 [2] [3] [4] $2,860,000 - 290,000 $800,000 - 50,000 $360,000 - 20,000 $ 40,000 (50,000) (10,000) 4,000 $ (6,000)

[5] Loss in 2011: Operating income Loss on sale of assets Loss before tax benefit Tax benefit (40% x $10,000) Loss on discontinued operations, net of tax benefit [6] [7] [8] [9]

$3,500,000 - 500,000 (sales from discontinued operation) $2,000,000 - 320,000 (cost of goods sold from discontinued operation) $675,000 - 40,000 (administrative expenses from discontinued operations) $312,000 - 30,000 (selling expenses from discontinued operations)

4-52

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-2
Requirement 1 JACKSON HOLDING COMPANY Comparative Income Statements (in part) For the Years Ended December 31 2011 Income from continuing operations before income taxes [1] .......................................... $3,000,000 Income tax expense .......................................... 1,200,000 Income from continuing operations .................. 1,800,000 Discontinued operations: Income from operations of discontinued component (including gain on disposal of $600,000 in 2011) [2] ........................................ 200,000 Income tax expense (benefit) ......................... 80,000 Income (loss) on discontinued operations ...... 120,000 Net Income ....................................................... $1,920,000 [1]

2010 $1,300,000 520,000 780,000

(300,000) 120,000 (180,000) $ 600,000

Income from continuing operations before income taxes: 2011 2010 Unadjusted $2,600,000 $1,000,000 Add: Loss from discontinued operation 400,000 300,000 Adjusted $3,000,000 $1,300,000 [2] Income from discontinued operations: 2011 Operating loss $(400,000) Gain on disposal 600,000 Total $ 200,000 2010 $(300,000) $(300,000)

4-53

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-2 (concluded) Requirement 2 The 2011 income from discontinued operations would include only the operating loss of $400,000. Since no impairment loss is indicated ($5,000,000 4,400,000 = $600,000 anticipated gain), none is included. The anticipated gain on disposal is not recognized until it is realized, presumably in the following year. Requirement 3 The 2011 income from discontinued operations would include the operating loss of $400,000 as well as an impairment loss of $500,000 ($4,400,000 book value of assets less $3,900,000 fair value).

4-54

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-3
Requirement 1 MICRON CORPORATION Partial Income Statement For the Year Ended December 31, 2011 Income from continuing operations before income taxes and extraordinary item......... Income tax expense ..................................... Income from continuing operations ............. Discontinued operations: Loss from operations of discontinued component (including loss on disposal of ................................................................... Income tax benefit ................................................................... Loss on discontinued operations ............... Income before extraordinary item ............... Extraordinary item: Loss from earthquake (net of $240,000 tax benefit) ...................... Net Income ..................................................
$300,000)

[1] $1,300,000 390,000 910,000

$(140,000) 42,000 [2] (98,000) 812,000 (560,000) $ 252,000

[1] Income from continuing operations before taxes: Unadjusted $1,200,000 Add: Gain from sale of factory 100,000 Adjusted $1,300,000 [2] Loss on discontinued operations: Operating income Deduct: Loss on sale of assets Loss before tax Tax benefit (30% x $140,000) Loss on discontinued operations $ 160,000 (300,000) (140,000) 42,000 $ (98,000)

4-55

Chapter 04 - The Income Statement and Statement of Cash Flows

Requirement 2 These events will not, or are unlikely to occur again in the near future. By segregating them, users are better able to predict future cash flows.

4-56

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-4

1. Restructuring is an example of an event that is either unusual or infrequent, but not both. Restructuring costs should be included in income from continuing operations but reported as a separate income statement component. The item is reported gross, not net of tax as with extraordinary gains and losses. 2. The extraordinary gain should be presented, net of tax, in the income statement below income from continuing operations. Also, earnings per share for income from continuing operations and for the extraordinary item should be disclosed. 3. The correction of the error should be treated as a prior period adjustment to beginning retained earnings, not as an adjustment to current year's cost of goods sold. In addition, the 2010 financial statements should be restated to reflect the correction, and a disclosure note is required that communicates the impact of the error on 2010 income.

4-57

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-5
ALEXIAN SYSTEMS, INC. Income Statement For the Year Ended December 31, 2011
($ in millions except per share date)

Net sales revenue ................................................. Cost of goods sold ............................................... Gross profit .......................................................... Operating expenses: Selling and administrative ................................. Restructuring costs ............................................ Total operating expenses ............................... Operating income ................................................. Other income: Interest revenue ................................................. Gain on sale of investments ............................... Total other income ......................................... Income before income taxes and extraordinary item .................................................................. Income tax expense ............................................. Income before extraordinary item ........................ Extraordinary gain (net of $48 in taxes) ...................... Net income ........................................................... Earnings per share: Income before extraordinary item ........................ Extraordinary gain ............................................... Net income ...........................................................
[1] $270 - 5 (prior period adjustment) [2] $154 - 26 (restructuring costs) [3] 40% x $15 [4] $120 less taxes of $48 (40% x $120) [2] $128

[1]

$425 265 160

26 154 6 3 6 9
[3] [4]

15 6 9 72 $ 81

$ 0.45 3.60 $ 4.05

Note: The difference in net income of $3 million ($81 million compared to $78 million on the original income statement) is the effect of the inventory error of $5 million, less the 40% tax effect.

4-58

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-6
REMBRANDT PAINT COMPANY Income Statement For the Year Ended December 31, 2011
($ in thousands, except per share amounts)

Sales revenue .................................................................... Cost of goods sold ............................................................ Gross profit ....................................................................... Operating expenses: Selling and administrative .............................................. Restructuring costs ........................................................ Operating income ............................................................. Interest income (expense), net .......................................... Income from continuing operations before income taxes and extraordinary item .................................................. Income tax expense .......................................................... Income from continuing operations before extraordinary item ............................................................................... Discontinued operations: Income from operations of discontinued component
(including gain on disposal of $2,000) ...................................

$18,000 10,500 7,500 $2,500 800

3,300 4,200 (150) 4,050 1,215 2,835

Income tax expense ....................................................... Income on discontinued operations .............................. Income before extraordinary item ..................................... Extraordinary gain (net of $900 tax expense) ...................... Net income......................................................................... Earnings per share: Income from continuing operations before extraordinary item ................................................................................ Income on discontinued operations .................................. Extraordinary gain ............................................................ Net income .......................................................................

400 120 280 3,115 2,100 5,215

$ 5.67 .56 4.20 $10.43

4-59

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-7

SCHEMBRI MANUFACTURING CORPORATION Combined Statement of Income and Comprehensive Income For the Year Ended December 31, 2011 ($ in 000s) $15,300 6,200 9,100 $1,300 800 1,200 3,300 5,800

Sales revenue ................................................................... Cost of goods sold .......................................................... Gross profit ..................................................................... Operating expenses: Selling ........................................................................... General and administrative ........................................... Restructuring costs ....................................................... Total operating expenses ........................................ Operating income ............................................................

Other income (expense): Loss on sales of investments ............................................................ $(220) Interest expense ............................................................................... (180) Interest revenue ............................................................................... 85 Other income (expense) ................................................................ Income from continuing operations before income taxes and extraordinary item ..................................................................... Income tax expense ......................................................... Income from continuing operations before extraordinary item .............................................................................. Discontinued operations: Income from operations of discontinued component (including gain on disposal of $1,400) ....................... 840 Income tax expense ...................................................... (336) Income from discontinued operations .......................... Income before extraordinary item ................................... Extraordinary item: Loss from earthquake (net of $800 tax benefit) ........... Net income....................................................................... Other comprehensive income: Unrealized gains from investments (net of $128 tax) 192 Loss from foreign currency translation (net of $96 tax) (144) Comprehensive income

(315) 5,485 2,194 3,291

504 3,795 (1,200) 2,595 48 $2,643

Problem 4-7 (concluded)

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Chapter 04 - The Income Statement and Statement of Cash Flows

Earnings per share:* Income from continuing operations before extraordinary item Discontinued operations Extraordinary loss Net income *Weighted-average shares = 1,000,000 + (400,000/2) = 1,200,000

$2.74 .42 (1.00) $2.16

Note: The depreciation expense error is a prior period adjustment (to retained earnings) and is not reported in the income statement.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-8

DUKE COMPANY Statement of Income and Comprehensive Income For the Year Ended December 31, 2011
$15,000,000 9,000,000 6,000,000 $1,000,000 500,000 300,000 400,000 2,200,000 3,800,000 (700,000) 3,100,000 1,240,000 1,860,000 (1,800,000) 60,000 (120,000) 108,000 (12,000) $ 48,000

Sales revenue ................................................................... Cost of goods sold .......................................................... Gross profit ..................................................................... Operating expenses: General and administrative ........................................... Selling .......................................................................... Restructuring costs ....................................................... Loss from write-down of obsolete inventory Total operating expenses .......................................... Operating income ............................................................ Other income (expense): Interest expense ............................................................ Income before income taxes and extraordinary item ....... Income tax expense ......................................................... Income before extraordinary item ................................... Extraordinary item: Loss from expropriation of overseas plant (net of $1,200,000 tax benefit) ............................................ Net Income....................................................................... Other comprehensive income (loss): Foreign currency translation adjustment loss, net of tax Unrealized gains on investment securities, net of tax Total other comprehensive loss Comprehensive income

Notes: 1. The restructuring costs and the loss from write-down of inventory are not extraordinary items. 2. The depreciation expense error is a prior period adjustment and is not reported in the income statement.

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Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-9
Requirement 1 Diversified Portfolio Corporation Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities: Collections from customers (1) Payment of operating expenses (2) Payment of income taxes (3) Net cash flows from operating activities Cash flows from investing activities: Sale of investments Net cash flows from investing activities Cash flows from financing activities: Proceeds from issue of common stock Payment of dividends Net cash flows from financing activities Increase in cash Cash and cash equivalents, January 1 Cash and cash equivalents, December 31 $880,000 (660,000) (85,000) $135,000 50,000 50,000 100,000 (80,000) 20,000 205,000 70,000 $275,000

(1) $900,000 in service revenue less $20,000 increase in accounts receivable. (2) $700,000 in operating expenses less $30,000 in depreciation less $10,000 increase

in accounts payable. (3) $80,000 in income tax expense plus $5,000 decrease in income taxes payable.

4-63

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-9 (concluded) Requirement 2 Diversified Portfolio Corporation Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities: Net income $120,000 Adjustments for noncash effects: Depreciation expense 30,000 Changes in operating assets and liabilities: Increase in accounts receivable (20,000) Increase in accounts payable 10,000 Decrease in income taxes payable (5,000) Net cash flows from operating activities $135,000

4-64

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-10
Requirement 1 2010 Cash: 2010 Cash + Net increase in cash = 2011 Cash 2010 Cash + 86 = 145 2010 Cash = 59 2011 A/R: 2010 A/R + Cr. Sales Cash collections = 2011 A/R 84 + 80 71 = 93 2010 Inventory: 2010 A/P + Purchases Cash Paid = 2011 A/P 30 + Purchases 30 = 40 Therefore, Purchases = 40 2010 Inventory + Purchases 2011 Inventory = Cost of goods sold 2010 Inventory + 40 60 = 32 2010 Inventory = 52 2010 Accumulated depreciation: 2011 accumulated depreciation less 2011 depreciation = 2010 accumulated depreciation 65 10 = 55

4-65

Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-10 (continued) 2010 Total assets: $59 + 84 + 52 + 50 + 150 55 = $340 2011 Total assets: $145 + 93 + 60 + 150 65 = $383 2010 Income taxes payable: 2010 Inc. taxes payable + Inc. tax expense Income taxes paid = 2011 Inc. taxes payable 2010 Inc. taxes payable =2011 Inc. taxes payable + Taxes paid Inc. tax expense 2010 Inc. taxes payable = 22 + 9 7 = $24 2011 Retained earnings: 2010 R/E + Net income Dividends = 2011 R/E 47 + 28 3 = 72 2010 Total liabilities and shareholders equity: $30 + 9 + 24 + 230 + 47 = $340 2011 Total liabilities and shareholders equity: $40 + 9 + 22 + 240 + 72 = $383

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Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-10 (concluded) Requirement 2 Grandview Corporation Statement of Cash Flows For the Year Ended December 31, 2011
($ in millions)

Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Gain on sale of investments Changes in operating assets and liabilities: Increase in accounts receivable1 Increase in inventory2 Increase in accounts payable3 Decrease in income taxes payable4 Net cash flows from operating activities
1 2 3 4

$ 28 10 (15) (9) (8) 10 (2) $14

$93 84 $60 52 $40 30 $22 24

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Chapter 04 - The Income Statement and Statement of Cash Flows

Problem 4-11

Santana Industries Statement of Cash Flows For the Year Ended December 31, 2011 ($ in thousands) $ 3,850 1,600 (300) (1,000) 150 300 100 200 (250) $4,650 (4,000) 500 (3,500)

Cash flows from operating activities: Net income Adjustments for noncash effects: Depreciation expense Changes in operating assets and liabilities: Increase in accounts receivable Increase in inventory Decrease in prepaid rent Increase in accounts payable Increase in interest payable Increase in unearned service revenue Decrease in income taxes payable Net cash flows from operating activities Cash flows from investing activities: Purchase of equipment Sale of equipment Net cash flows from investing activities

Cash flows from financing activities: Proceeds from loan payable 5,000 Payment of dividends (1,000) Net cash flows from financing activities 4,000 Net increase in cash Cash, January 1 Cash, December 31 5,150 2,200 $7,350

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CASES Requirement 1 The term earnings quality refers to the ability of reported earnings (income) to predict a companys future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value.

Judgment Case 4-1

Requirement 2 To enhance predictive value, analysts try to separate a companys transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future. Requirement 3 An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Requirement 4 You would consider the size of the gain in relation to net income, the size of the companys investment portfolio, and the frequency of gains and losses from the sale of investment securities in past years. The main objective is to determine the likelihood of this type of gain occurring again in the future. Requirement 1 Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations. Facility closings and related employee layoffs translate into costs incurred for severance pay and relocation costs as well as asset write-downs or write-offs.

Judgment Case 4-2

Requirement 2 Prior to 2003, restructuring costs were recognized (expensed) in the period the decision to restructure was made, not in the period or periods in which the actual activities took place. Now, restructuring costs are expensed in the period(s) incurred. Requirement 3 Restructuring costs would be included as an operating expense in a multi-step income statement. Requirement 4 An analyst must interpret restructuring charges in light of a companys past history in this area. Information in disclosure notes describing the restructuring and management plans related to the business involved also can be helpful.

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No. Companies generally prefer to report earnings that Judgment Case 4-3follow a smooth, regular, upward path. They try to avoid declines, but they also want to avoid increases that vary wildly from year to year. It is better to have two years of 15% earnings increases than a 30% gain one year and none the next. As a result, some companies bank earnings by understating them in particularly good years and use the banked profits to increase earnings in bad years. Requirement 1 Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings calculated according to GAAP. These pro forma earnings numbers are managements view of permanent earnings. These pro forma earnings numbers are controversial as they represent managements biased view of permanent earnings and should be interpreted in that light.

Real World Case 4-4

Requirement 2 The term earnings quality refers to the ability of reported earnings (income) to predict a companys future earnings. Management believes that pro forma earnings are of much higher quality than reported earnings because they are more indicative of future profitability. Requirement 3 There are some obvious reconciling items, to include restructuring costs and other special charges of $1,170 million, inventory charges of $2,249 million and in-process research and development of $109 million. Cisco offered the following reconciliation ($ in millions): GAAP loss Add: Restructuring costs and other special charges In-process research and development Amortization of goodwill and other acquisition costs* Payroll tax on stock options exercised Inventory charges Total adjustments Tax effects (approximately 24.7% tax rate) Net of tax adjustments Pro forma net income $(2,693) $1,170 109 346 10 2,249 3,884 961 2,923 $ 230

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*New accounting standards discussed in Chapters 10 and 11 require that goodwill no longer be amortized. This standard became effective after August of 2001.

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Communication Case 4-5

The critical question that student groups should address is whether or not the gain on the sale of the timber tracts should be reported as an extraordinary item on the 2011 income statement. There is no right or wrong answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. Solutions should address the following issues: 1. Is the gain material? A consensus should be reached that the gain is material. 2. Is the event both unusual and infrequent? Debate should center on the critical issue of whether the event is likely to occur again in the foreseeable future. 3. If the event is deemed to require presentation as an extraordinary item, the gain should be reported net of tax below income from continuing operations. A disclosure note also is required and earnings per share disclosure should reflect the income statement presentation. As a real world example of a similar situation, in 1974 Johns Manville Corporation, manufacturer of asbestos products, reported a $21 million extraordinary gain from the sale of timber tracts. No disclosure note was provided to explain the event, so we can only speculate as to the circumstances leading to the company's presentation of the gain as extraordinary. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.

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Communication Case 4-6

Suggested Grading Concepts and Grading Scheme: Content (70%) _______ 10 Is the loss material? _______ 25 Lists the alternative treatments. ______ Present before-tax amount as a separate line item. ______ Present the after-tax amount as an extraordinary item. ______ In either case, disclosure is required. _______ 25 Cites the appropriate authoritative pronouncement, FASB ASC 225-20-45 (previously APBO No. 30), and discuss the concepts of unusual and infrequent in the context of the companys environment. _______ 10 A clear, well-supported recommendation is made. ______ _______ 70 points Writing (30%) _______ 6 Terminology and tone appropriate to the audience of a chief financial officer. _______ 12 Organization permits ease of understanding. ______ Introduction that states purpose. ______ Paragraphs that separate main points. _______ 12 English ______ Sentences grammatically clear and well organized, concise. ______ Word selection. ______ Spelling. ______ Grammar and punctuation. ______ _______ 30 points

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Case 4-6 (continued) The following is provided as an example. August, 1990 TO: Chief Financial Officer, Carter Hawley Hale Stores (CHHS) FROM: John Doe, Controller (CHHS) RE: Income Statement treatment of October 17, 1989, earthquake damage costs.

A decision on the income statement treatment of the earthquake damage costs involves a number of considerations. First, the damage costs are clearly material. Inclusion of the costs in earnings results in an increase in the net loss for the fiscal year ended August 4, 1990, from $9.47 million to $25.97 million. This leaves us only two options for the income statement presentation of the loss: 1. Present the before-tax amount of the loss ($27.5 million) as a separate line item in the income statement. 2. Present the after-tax effect of the loss ($16.5 million) as an extraordinary item, below income from continuing operations. In both cases, a disclosure note would be required to explain the loss. The appropriate authoritative pronouncement pertaining to this case is FASB ASC 225-20-45: Income Statement-Extraordinary and Unusual Items-Other Presentation Matters (previously Accounting Principles Board Opinion No. 30). It states that judgment is required in determining whether or not an event warrants separate reporting in the income statement as an extraordinary item. However, the following broad guideline is provided in paragraph 2:
Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence.

The characteristics of unusual nature and infrequency of occurrence must be considered in light of the environment in which the company operates. These characteristics are only aids in answering the important question: What is the likelihood that this event will occur again in the foreseeable future? If it is not likely to occur again, then this should be communicated to financial statement users by segregating the income effect of the event as an extraordinary item. This will help them in using the income statement to predict future cash flows.

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Case 4-6 (concluded) RECOMMENDATION I recommend that the earthquake damage costs be treated as an extraordinary loss, net of tax, in the income statement for the fiscal year ended August 4, 1990. In addition, earnings per share for income both before and after the loss must be presented. While many earthquakes do occur in California, extremely large earthquakes causing significant amounts of damage are both unusual and infrequent. I do not believe that this type of loss will occur again in the foreseeable future.

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Ethics Case 4-7

Discussion should include these elements.

Facts: The company incurred $10 million in expenses related to a product recall. The company had experienced product recalls in the past and they do occur in the industry. To show a profit from continuing operations, Jim Dietz, the controller, wants to report the $10 million as an extraordinary loss, rather than as an expense included in operating income. He tells the CEO that the company has never had a product recall of this magnitude and that the company fixed the design flaw and upgraded quality control. Extraordinary items are gains and losses that are material, and result from events that are both unusual and infrequent. These criteria must be considered in light of the environment in which the entity operates. There obviously is a considerable degree of subjectivity involved in the determination. The concepts of unusual and infrequent require judgment. In making these judgments, an accountant should keep in mind the overall objective of the income statement. The key question is how the event relates to a firms future profitability. If it is judged that the event, because of its unusual nature and infrequency of occurrence, is not likely to occur again, separate reporting as an extraordinary item is warranted. Ethical Dilemma: It appears from the facts of the case that it would be difficult for the company to come to the conclusion that a material product recall is not likely to occur again in the foreseeable future. This type of event has occurred before and is common in the industry. While a subjective judgment, extraordinary treatment of the $10 million does not appear warranted. Is the obligation of Jim and the CEO to maximize income from continuing operations, the company's position on the stock market and management bonuses stronger than their obligation to fairly present accounting information to the users of financial statements? Who is affected? Jim Dietz CEO and other managers Other employees Shareholders Potential shareholders from the stock market Creditors Company auditors

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Research Case 4-8


Requirement 1 The accounting standards topic number that addresses exit or disposal cost obligations is FASB ASC 420: Exit or Disposal Cost Obligations. Requirement 2 The specific citation that addresses the initial measurement of these obligations is FASB ASC 42010301: Exit or Disposal Cost ObligationsOverallInitial Measurement. Requirement 3 A liability for a cost associated with an exit or disposal activity is measured initially at its fair value in the period in which the liability is incurred. Requirement 4 The specific citation that describes the disclosure requirements for exit or disposal obligations is FASB ASC 42010501: Exit or Disposal Cost ObligationsOverall Disclosure.

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Case 4-8 (concluded) Requirement 5 All of the following information is disclosed in notes to financial statements that include the period in which an exit or disposal activity is initiated and any subsequent period until the activity is completed: a. A description of the exit or disposal activity, including the facts and circumstances leading to the expected activity and the expected completion date
b. For each major type of cost associated with the activity (for example, one-time

employee termination benefits, contract termination costs, and other associated costs), both of the following is disclosed: 1. The total amount expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date 2. A reconciliation of the beginning and ending liability balances showing separately the changes during the period attributable to costs incurred and charged to expense, costs paid or otherwise settled, and any adjustments to the liability with an explanation of the reason(s) why. c. The line item(s) in the income statement or the statement of activities in which the costs in (b) are aggregated d. For each reportable segment, as defined in Subtopic 280-10, the total amount of costs expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date, net of any adjustments to the liability with an explanation of the reason(s) why e. If a liability for a cost associated with the activity is not recognized because fair value cannot be reasonably estimated, that fact and the reasons why.

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Judgment Case 4-9 Situation 1. 2. 3. 4. 5. 6. 7. 8. Treatment (a-g) b c f g a b e d. Financial Statement Presentation (CO, BC, or RE) CO RE CO CO BC CO BC RE

1. The loss is not unusual or infrequent. It is included in Judgment Case 4-10 income from continuing operations along with other nonoperating items. 2. The sale of the financing component is treated as a discontinued operation. The gain or loss from the sale of the assets along with income or loss generated by the component is presented below income from continuing operations. 3. A change in depreciation method is treated as a change in accounting estimate achieved by a change in accounting principle. Changes in estimates are accounted for prospectively. The remaining book value is depreciated, using the new method, over the remaining useful life. 4. This event is not unusual but may be infrequent. It usually is presented as a separate line item included in income from continuing operations. 5. The correction of an error is treated as a prior period adjustment. The effect of the correction is not included in income, but as an adjustment to retained earnings. Prior years financial statements are restated to correct the error. 6. This event requires no unusual treatment. The lipstick line does not qualify as a component of an entity requiring treatment as a discontinued operation. The loss on sale of the assets of the product line is included in continuing operations.

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IFRS Case 4-11

Requirement 1 1. GSK reported interest received and dividends from associates and joint ventures as investing cash flows. U.S. GAAP requires these items to be included with operating cash flows. 2. Interest paid is reported as a financing cash flow. U.S. GAAP requires interest paid to be included with operating cash flows Requirement 2 GSK could have combined its income statements and statements of comprehensive income into a single statement. U.S. GAAP allows the presentation of other comprehensive income in one of three ways: (a) included as an extension to the income statement, (b) reported (exactly the same way) as a separate statement of comprehensive income, usually as part of a disclosure note, or (c) included in the statement of changes in shareholders equity.

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Judgment Case 4-12

Requirement 1 1. a. As a component of operating income. 2. b. As a nonoperating income item. 3. d. As an other comprehensive income item. 4. b. As a nonoperating income item. 5. c. As a separately reported item. 6. a. As a component of operating income. 7. e. As an adjustment to retained earnings. 8. c. As a separately reported item. Requirement 2 Situations 3, 5, and 8 would be reported in the statement of income and comprehensive income net-of-tax. Also, the net-of-tax effect of the correction of the amortization error, situation 7, would increase or decrease retained earnings.

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Judgment Case 4-13

It would be nice to think that management makes all accounting choices in the best interest of fair and consistent financial reporting. Unfortunately, other motives influence the choices among accounting methods and whether to change methods. It has been suggested that the effect of choices on management compensation, on existing debt agreements, and on union negotiations each can affect managements selection of accounting methods. For instance, research has suggested that managers of companies with bonus plans are more likely to choose accounting methods that maximize their bonuses (often those that increase net income). Other research has indicated that the existence and nature of debt agreements and other aspects of a firms capital structure can influence accounting choices. Whether a company is forbidden from paying dividends if retained earnings fall below a certain level, for example, can affect the choice of accounting methods. Choices made are not always those that tend to increase income. As you will learn in Chapter 8, many companies use the LIFO inventory method because it reduces income and therefore reduces the amount of income taxes that must be paid currently. Also, some very large and visible companies might be reluctant to report high income that might render them vulnerable to union demands, government regulations, or higher taxes.
1 2 3 4

1 Watts, R.L. and J.L. Zimmerman, Towards a Positive Theory of the Determination of Accounting Standards, The

Accounting Review, January, 1978, and Positive Accounting Theory: A Ten Year Perspective, The Accounting Review, January, 1990. 2 For example, see Healy, P.M., The Effect of Bonus Schemes On Accounting Decisions, Journal of Accounting and Economics, April, 1985, and Dhaliwal, D.G. Salamon, and E. Smith, The Effect of Owner Versus Management Control On The Choice Of Accounting Methods, Journal of Accounting and Economics, July, 1982. 3 Bowen, R.M., E.W. Noreen, and J.M. Lacy, Determinants of the Corporate Decision To Capitalize Interest, Journal of Accounting and Economics, August, 1981. 4 This political cost motive is suggested by Watts, R.L. and J.L. Zimmerman, Positive Accounting Theory: A Ten Year Perspective, The Accounting Review, January, 1990, and Zmijewski, M., and R. Hagerman, An Income Strategy Approach To The Positive Theory of Accounting Standard Setting/Choice, Journal of Accounting and Economics, August, 1981. 4-82

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Research Case 4-14


(Note: This case requires the student to reference a journal article.]

Requirement 2 The authors use the S&P 500 companies as their sample. Requirement 3 77 percent in 2001 and only 54% in 2003. Requirement 4 In 2001, 85% of firms have greater pro forma than GAAP earnings. This ratio declined to 67% in 2003. Requirement 5 In 2001, 136 firms reported Restructuring Charges, and the same number of firms reported a Divestiture/Sale of Business Units. In 2003, the most frequently reported adjustment was Amortization/Impairment of Goodwill and Other Intangibles. Requirement 6 The authors main conclusions are that the introduction of pro forma regulation is associated with a substantial change in firms pro forma reporting. Notably, far fewer firms are reporting pro forma earnings, while those that continue to report appear to do so in a manner consistent with the intention of the regulation, to provide useful information, not to mislead.

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Integrating Case 4-15

DEFICIENCIES: Balance Sheet: 1. The asset section of the balance sheet should be classified. Cash, short-term investments, accounts receivable, and inventories should be included as current assets. 2. Accounts receivable should be shown net of the allowance for uncollectible accounts. 3. Inventories - the method used to cost inventory should be disclosed in a note. 4. Marketable securities - $21,000 of investments ($78,000 - 57,000) should be classified in a noncurrent investments category. 5. Property and Equipment - should be classified in a separate category. Original cost should be disclosed along with the accumulated depreciation to arrive at the net amount. Also, the method used to compute depreciation should be disclosed in a note. 6. The liability and shareholders' equity section of the balance sheet should be classified into (1) current liabilities, (2) long-term liabilities, and (3) shareholders' equity. 7. Current liabilities should include accounts payable and accruals, notes payable (the $80,000 note due in 2012 and the $60,000 installment on note # 2 due in 2012). The latter should be classified as current maturities of long-term debt. Also, note disclosure is required for the notes providing information such as payment terms, interest rates, and collateral pledged as security for the debt. 8. Long-term liabilities should include the $60,000 second installment on note #2. 9. Common stock - the par value, if any, and the number of shares authorized, issued and outstanding should be disclosed. Income Statement: 1. The miscellaneous expense should be classified as an extraordinary item and shown net of tax below income from continuing operations. A note should describe the event. 2. Earnings per share disclosure is required. 3. The restructuring charges should be shown as a separate operating expense item in the income statement and described in a note.

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Financial Analysis Case 4-16


Requirement 1 2008 to 2009: ($2,478 2,947) $2,947 = 2007 to 2008: ($2,947 2,583) $2,583 = 15.9% decrease 14.1% increase

Requirement 2 Provision for income taxes Income before taxes $846 $3,324 = 25% = approximate income tax rate Requirement 3 $2,478 $61,101 = 4% Answers to the questions will, of course, vary Real World Case 4-17because students will research financial statements of different companies. No specific standards dictate how income from continuing operations must be displayed, so companies have considerable latitude in how they present the components of income from continuing operations. This flexibility has resulted in a considerable variety of income statement presentations. However, we can identify two general approaches, the single-step and the multiple-step formats that might be considered the two extremes, with the income statements of most companies falling somewhere in between. The presentation of separately reported items, however, is mandated and students should be able to easily identify them.

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British Airways Case


Requirement 1 BA classifies its expenses by both natural descriptions (e.g. employee costs, fuel and oil costs, and landing fees) and functions (e.g. restructuring costs and selling costs). In the U.S., expenses are classified by function. Requirement 2 BA classifies interest paid as an operating cash flow and interest received and dividends received as investing cash flow. Under IFRS, companies can report interest paid as either an operating or financing cash flow and interest and dividends received as either operating or investing cash flows.

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